Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

On July 30, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Israel.1

Background

From mid-1999 until the third quarter of 2000, Israel experienced the best economic performance in many decades. Real GDP grew buoyantly, accelerating toward the third quarter of 2000, when the growth rate (seasonally adjusted) reached an annualized 9 percent. Despite rapid demand growth and the sharp increase in the price of imported oil, the inflation rate continued to decline, reaching zero by September 2000.

The rapid growth came to a sudden and decisive end in the fourth quarter of 2000, against the background of the outbreak of violence in late September and the global decline of the high-tech industry. Real GDP shrank by 9.8 percent (seasonally adjusted annual rate), and although the slide stopped in the first quarter of 2001, no monthly indicators are yet showing a sign of rebound.

However, notwithstanding the very serious deterioration in the economic and security environment, key financial market variables, such as exchange rate, the country risk premium, and market-based inflationary expectations, have remained broadly stable. They deteriorated marginally in late last year and early this year, but have largely returned to their original levels.

Monetary policy remained tight in 2000. Nominal interest rates declined as the Bank of Israel cut its policy rate steadily, but due to the deceleration of inflation and the appreciation of the sheqel, monetary conditions continued to tighten. CPI inflation was zero percent at end-2000, substantially below the official target of 3-4 percent.

Buoyant economic activity during the first three quarters of 2000 contributed to a major improvement in the budget. The central government budget recorded a balance (i.e., zero deficits) in 2000, substantially bettering the targeted 2½ percent of GDP deficit. The 2001 budget aims at a deficit of 1¾ percent of GDP, but the deficit is likely to be larger due to a revenue shortfall resulting from the economic slowdown.

As concerns structural reforms over the past year, the tax reform package proposed in May 2000 has been stalled, no steps have been taken on the revision of the Bank of Israel Law, and bank privatization has been slow.

The nature of recent shocks makes short-term forecasting particularly difficult. The depth and length of the current downturn will depend on the evolution of the security situation, as well as the behavior of the NASDAQ and the global high-tech demand. The staff projects growth in 2001 at 1¾ percent, pulled down by weak exports and fixed capital investment, and CPI inflation at end-2001 to be at or below the lower bound of the target range (2½-3½ percent). Provided that the security situation and the global demand improve, growth next year could rise to 4-5 percent reflecting Israel's high potential.

Executive Board Assessment

Executive Directors commended the authorities' skillful macroeconomic policies over the past few years, as evidenced by the achievement of rapid economic growth with low inflation in the first three quarters of 2000. However, security problems since end-September, together with a global turnaround of the high-tech boom on which growth had largely depended, led to a sharp contraction in the following quarter and a lackluster subsequent performance. Against this backdrop, Directors agreed that the authorities' central task is to consolidate progress toward macroeconomic stability while minimizing the economic costs of the current slowdown and strengthening the structural foundations for future growth.

Directors observed that the stability of the exchange rate and of inflationary expectations, in spite of the major shocks to the economy, is in no small part due to the authorities' success in establishing credibility on both the fiscal and monetary policy fronts. It will be important, in the coming months, to maintain this hard-won credibility, through continued prudent fiscal and monetary policies, while utilizing any room to moderate the downturn. More specifically, Directors agreed that the policy mix that would best achieve this objective involves measured monetary easing as long as the inflationary outlook stays within the government inflation target range, and continued fiscal, and notably expenditure, discipline.

Directors endorsed the authorities' gradual approach to monetary easing in light of the risk that a negative market reaction, especially from the foreign exchange market, could jeopardize the inflation target. They appreciated that the Bank of Israel is carefully balancing signs of diminishing vulnerability of the economy to a depreciation/inflation spiral against a variety of other factors, including the need to further entrench the low-inflation environment.

Directors noted the inconsistency between the crawling exchange rate band and inflation targeting, and discussed various options for removing the inconsistency. Most Directors encouraged the authorities to move more rapidly to a pure inflation targeting regime by abolishing the band.

Directors welcomed the authorities' commitment to offset increases in defense-related expenditure by cuts in other expenditure categories as a useful signal to the market that fiscal discipline will be maintained. They agreed that if revenues fall short of projections because of the slowdown, then the automatic stabilizers should be allowed to operate. This would imply permitting a limited deviation from the deficit target this year, in order not to accentuate the economic downturn. Directors strongly endorsed the authorities' commitment to a path of fiscal consolidation up to 2003 that calls for continued progress in reducing deficits, as well as the ratios of debt and spending to GDP. They considered that this commitment would gain in credibility by being presented in the context of a medium-term fiscal framework, which would strengthen the position of the authorities in resisting ad hoc requests to loosen fiscal discipline and would underpin longer-term fiscal reform initiatives, including in the area of social spending. Directors urged a shift towards the use of a conventional budget balance measure in budget presentations. A number of Directors also highlighted the need for further improvements in fiscal transparency and encouraged the authorities to undertake a fiscal ROSC to inform and support efforts in this area.

Directors were encouraged by the favorable findings of the Financial Sector Stability Assessment, but urged the authorities to address a number of problems, including the limited coordination among supervisors and the government's provision of non-marketable assets to institutional investors, which have stifled the development of capital markets. They also encouraged the authorities to move swiftly in implementing the anti-money laundering regime and achieving compliance with international standards. They welcomed the recent revival of the discussions on the revision of the Bank of Israel Law and the restatement of support for the independence of the Bank of Israel. They encouraged the authorities to implement expeditiously the Levin Committee's recommendations, specifically by presenting to the Knesset an amendment to the Bank of Israel Law that would establish price stability as the main objective of monetary policy and ensure the central bank's independence.

Directors emphasized the importance of structural reforms, in particular tax reform and privatization, that will enhance the medium-term growth potential of the economy.

Directors observed that Israel meets the Special Data Dissemination Standard specifications for coverage, periodicity, and timeliness of the data, and that the quality of the data is adequate for the purpose of surveillance.

1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. This PIN summarizes the views of the Executive Board as expressed during the July 30, 2001 Executive Board discussion based on the staff report.